Trade and FDI-related impacts of Brexit

Transcription

1 Trade and FDI-related impacts of Brexit María C. Latorre (Universidad Complutense de Madrid) Zoryana Olekseyuk (Deutsches Institut für Entwicklungspolitik) Hidemichi Yonezawa (ETH Zurich) Abstract We offer a general equilibrium analysis of Brexit incorporating the state-of-the-art differences in productivity and firms selection within manufacturing sectors à la Melitz (2003) and multinationals in services. Trade, output and average productivity diminish across most sectors in the UK and the Rest of the European Union (REU), as well as GDP, welfare, wages and capital remuneration. However, the UK loses more due to the missing preferential access to the huge EU market. Emergence of barriers against multinationals explains approximately one third of the negative effect in both the UK and REU. Other regions remain nearly unaffected. Keywords: Multinationals, CGE, Melitz, monopolistic competition, trade in services. JEL codes: C68, F14, F15, F17, F21 1

2 Introduction In her speech in Mansion House on the 3 rd of March 2018, Prime Minister Theresa May confirmed that the UK will leave the single market and customs union after the transition period which is expected to last until the end of During this transition period, the UK will continue to trade freely within the common market. The Prime Minister strives for a comprehensive trade agreement that should address services as well as goods in the future. She has also suggested, Britain would commit to keeping some EU regulations and standards, while reserving the option to diverge in others. However, the EU has dismissed this latter idea and there seem to be vast disagreement between both sides a year before Brexit in March Note that a comprehensive trade agreement, such as the one between the EU and Canada (CETA), took seven years of negotiations. It seems we will still have to wait for long to see how the final trade agreement will look like. Michael Barnier, the EU chief negotiator, has mentioned: nothing is agreed until everything is agreed (Wall Street Journal, 2018a). With this background, we address the following questions in this paper: Could the UK or EU win after Brexit? Or, if both sides are hurt, who will be more harmed? Will the UK or EU be able to recover much of its lost trade after Brexit in other regions of the world? Who wins in that trade with third nations? What is the role of UK and European multinationals? Modelling a disintegration process constitutes a rather original analysis. 1 However, the economic effects of Brexit have been studied and reviewed in a few papers (e.g., Busch and Matthes, 2016; Latorre et al., 2018a and Fernández-Pacheco et al., 2018). The consensus is that it will generate an asymmetric negative outcome in which UK will lose more than the Rest of the European Union (REU, henceforth). This paper analyses the impact of two dimensions of Brexit, namely, trade and foreign direct investment (FDI). It aims at quantifying its effects on a sectoral and aggregate level for several regions, with a focus on potential effects on foreign multinationals in services and productivity impacts in manufacturing. We use a Computable General Equilibrium (CGE) model with 21 sectors, 11 regions and 4 factors of production, which incorporates a Melitz (2003) structure in manufactures and foreign multinationals operating under imperfect competition in services. This combination has not been previously attained in a multiregional framework, to the best of our knowledge. Our analysis provides original estimations of Brexit impact and contributes to the literature along four broad fronts. First, with respect to the mainstream analysis in international economics (e.g., Costinot and Rodríguez-Clare, 2014), we incorporate more simultaneous features of real economies. These include: multiple sectors, regions and factors of production; trade imbalances; intermediates with demand structures reflecting actual data; sector-specific tariffs as well as Non-Tariff Barriers (NTBs) to trade and FDI; multinationals operating in services sectors; and a competitive selection of 1 As the last decades are characterized by the deepening of economic integration and the fall in barriers to trade and FDI, studies tend to investigate integration processes (e.g., Yonezawa and Latorre, 2018; Latorre et al., 2018; Ortiz and Latorre, 2017). Some scarce exceptions, however, can be found in the analysis of disinvestments (Gómez-Plana and Latorre, 2014), of FDI decreases during the crisis (Latorre and Hosoe, 2016) and of Crimea s annexation from Ukraine (Olekseyuk and Schuerenberg-Frosch, 2016). 2

3 heterogeneous manufacturing firms (following Melitz, 2003). While Costinot and Rodríguez-Clare (2014) empirically analyse the impact of some of these realistic features, they do it only in an Armington framework of perfect competition. As noted by Balistreri and Tarr (2017), the exact hat algebra literature, which is elaborated by Arkolakis et al. (2012), has not produced a solution to the Melitz models yet, that incorporates realistic data and features of the economies. Second, most of the previous studies on Brexit have been done in an Armington perfect competition setting (e.g., Aichele and Felbermayr, 2015; Dhingra et al., 2017; Ottaviano et al., 2014; Ciuriak et al., 2015). The debated equivalence of welfare impacts of trade among Armington, Krugman and Melitz structures suggested by Arkolakis et al. (2012) holds only in a very restrictive setting. This has been demonstrated empirically by Costinot and Rodríguez-Clare (2014) and Balistreri and Tarr (2017) and reviewed extensively by Akgul (2017). In general, welfare impacts tend to be larger for Melitz than Krugman or Armington structure (Balistreri and Tarr, 2017; Akgul, 2017). Thus, most of the analyses of Brexit with the Armington setting could be considered as a lower bound impact. However, Balistreri and Tarr (2017) and Olekseyuk and Balistreri (2017) demonstrate that a Melitz structure may also yield lower impacts than Krugman or Armington in some cases. In this sense, modelling productivity differences across firms within sectors and firms selection to bilateral markets is an appropriate approach accounting for the features of real economies (e.g., Bernard et al., 2007). Third, compared to most of other approaches to study Brexit, we quantify the effects for a wider range of macro and microeconomic variables. We study (bilateral and total) exports and imports, together with output, productivity and variety effects at the sectoral level. We show the impact for the average industry productivity as well as the average productivity of domestic firms (i.e., firms that sell only domestically) across manufacturing sectors. In addition, we provide details on the number of varieties lost due to the higher barriers against foreign competitors that Brexit implies. In comparison, previous Brexit studies with Melitz structure or imperfect competition (e.g., Hosoe, 2018; Jafari and Writz, 2017) provide no evidence on average productivity and varieties available for consumption. Moreover, we offer the whole range of macroeconomic variables for the eleven regions of our model, together with a deep analysis of the microeconomic effects for both the REU and UK. Since our study covers several regions and variables, such setting supports comparison of the coherence and consistency of the results. Fourth, we additionally incorporate multinationals in services into the path-breaking CGE model of Balistreri et al. (2011) with the full Melitz structure in several sectors. Such inclusion of multinationals and FDI is not implemented in most of the Brexit analyses as well as generally in CGE models. Given the particularly intense specialization of UK economy in services, such as finance, insurance, telecommunications and business services, an analysis of mode 3 provision of services (i.e., through foreign affiliates sales) is of high relevance. Our results suggest that the UK experiences much more sizeable losses in its welfare, foreign trade, production, average industry productivity, wages and capital remuneration than the REU does. A hard Brexit (i.e., reversion to WTO rules) would reduce welfare in the UK by -3.17% (in REU by %), while the impact of a soft Brexit (e.g., a post-brexit arrangement similar to Norway) would be about a half of the negative impact of the hard one in both regions. We also observe higher 3

4 welfare losses along the extensive margin for the UK illustrating the fact that the UK loses many imported varieties (produced by highly productive European firms) with low prices and high quantities, while the new domestic varieties are produced by firms with lower productivity and therefore at high prices and small quantities. Indeed, the results for average productivity of domestic firms in the UK confirm this with a decline by up to -2.27% in several manufacturing sectors such as textiles, chemicals, motor vehicles and electronics. Thus, less productive firms enter the British market due to increased protectionism and reduced import competition. Moreover, our inclusion of FDI in services also constitutes an extra source for losses, which has often been neglected in other general equilibrium assessments. More precisely, an increase in FDI barriers explains approximately one third of the overall fall in GDP, welfare and wages in the UK and REU. Concerning outsiders (i.e., US, China, India, Japan, other advanced economies, South East Asia, Latin America, Middle East and Sub-Saharan Africa), the impact is negligible at the aggregate level. 2 Our study has the following structure. In section 2, we provide an overview of the production and trade structure of the REU and UK. In section 3, we explain the model structure and scenarios. In section 4, we analyse sectoral and aggregate outcomes, while section 5 offers a sensitivity analysis for our results. Main conclusions are presented in section 6. The algebraic description of the model is offered in an online appendix. 2. Trade and production structure of the UK and the Rest of the European Union (REU) Table 1 and 2 offer data on capital and labour intensity, value added, as well as several indicators related to exports and imports for the REU and UK, respectively. The information is available for the 21 sectors included in the model. 3 The bottom rows of the table also show some summarizing aggregates for manufacturing, services and for all the sectors. The information refers to 2020, which is the base year in our modelling application. 4 The first two columns present information on capital and labour intensity across sectors. In particular, we offer each sector s share of labour and capital remuneration in total costs. 5 The structure of value added (i.e., the shares of all the sectors in total value added of the economy) appears in the third column. The next columns display the weight of each sector in aggregate exports and imports and the shares of each of the Brexit partners (i.e., the UK and REU) in exports and imports of the other partner. In the case of REU, we also present the share of intra-eu imports and exports in separate columns, given its importance for trade within the REU. 2 Our negative results are lower than the ones obtained in macro models that include uncertainty (e.g., HM Treasury, 2016a, 2016b; OECD, 2016). However, uncertainty has failed to materialize so far, even though it seems there should have been scope for that to happen (Wall Street Journal, 2018b). See Latorre et al. (2018) and Fernández-Pacheco et al. (2018) for a comprehensive comparison of Brexit studies including ours. 3 Appendix 1 presents sectors description and their mapping between different sectoral classifications. 4 We update the initial data for 2011, which is the latest version available of the database GTAP 9 (Aguiar et. al., 2016), using IMF (2016) projections. See section 3 for details. 5 The total costs of production include expenses not only for labor and capital, but also for intermediate inputs, for land in agriculture and for natural resources in agriculture and other primary goods. Therefore, reported labor and capital shares in Table 1 and 2 represent just a part of total costs. 4

5 We can see that in the REU and in UK services sectors are more labour intensive and tend to generate a larger share of value added per unit of production than manufactures (i.e., the sum of labour and capital remuneration shares in total costs is larger in services than in manufactures). 31.4% and 36.7% of total costs in services sectors go to labour remuneration in the REU and in UK, respectively. On the other hand, the services specialization of the UK is more intense than the one in the REU. Their respective shares in total value added are of 75.9% vs 67.2%. However, looking at the next columns, we see that contrasting with the structure of value added the bulk of trade is concentrated in manufacturing. This reflects a global tendency, which has been analysed in detail in Latorre and Yonezawa (2018) and Latorre et al. (2018b). Table 2 shows that the REU is a crucial trade partner for UK. 46.9% and 48.4% of UK s aggregate exports and imports, respectively, take place with the REU. This dependency is of much relevance in general across all the sectors. The UK, by contrast, explains only around 6.3% (of exports) or 5.3% (of imports) of REU trade, once intra-eu trade has been taken into account (see Table 1). The bulk of REU trade within the EU-27 is very high with 49.2% and 52.3% of its total exports and imports, respectively. However, intra-reu trade is more important for manufactures than for services. Similarly, the UK is more integrated in services than in manufactures with third nations. In other words, within the former EU-28 trade integration was stronger in manufacturing than in services. [TABLE 1 and 2] 3. Model and simulations This study applies an original multi-region, multi-sector and multi-factor general-equilibrium simulation model to evaluate the impact of Brexit. 6 One of the innovations is that our model is among the few CGEs incorporating the operations of foreign multinationals (Tarr, 2013 and Latorre, 2009) in advanced services sectors. 7 The impact of FDI varies depending on the services sector to which they accrue, which is in accordance with the fact that the effects of multinationals vary across sectors (Zhou and Latorre, 2014a,b; Latorre, 2013; Latorre, 2012). Data on the sales of foreign multinationals across different regions and services stem from the US International Trade Commission Database (Fukui and Lakatos, 2012). Moreover, we apply a competitive selection model of heterogeneous firms consistent with Melitz (2003) in manufactures and construction. 8 Simultaneously, services sectors with multinationals operate under monopolistic competition á la Krugman (1980) which, therefore, implies firm level product differentiation of symmetric varieties. The rest of sectors exhibit a climate of perfect competition and constant returns to scale. 6 The complete algebraic description of the model can be found in the online appendix. 7 The advanced services sectors include water transport, air transport, communication, finance, insurance and business services. 8 We model a Melitz structure in manufacturing sectors with the share of intra-industry trade over 60% of total trade following Olekseyuk and Balistreri (2017). This is the case for food, textiles, chemicals, metals, motor vehicles, other transport, electronics, other machinery, other manufactures and construction, i.e., all manufacturing sectors except for wood and paper as well as other primary products. This matches the idea that a climate of monopolistic competition is related to trade in different varieties of the same product. 5

6 Our model is innovative as it applies Melitz structure to more than one manufacturing sector and jointly allows for the presence of multinational firms supplying business services in the host country. While each of the aforementioned characteristics had already been attained in CGE models, their combination in all of the regions of a CGE model had not been previously achieved, to the best of our knowledge. Let us put these characteristics in perspective with other models. Several CGEs include a Melitz structure but it tends to be constrained to one sector only (e.g., Dixon et al., 2016; Akgul et al., 2016; Oyamada et al., 2015), while in the present paper we include it in ten manufacturing sectors. Others include Melitz in several sectors of a CGE model (Hosoe, 2018; Petri and Plumer, 2016; Petri et al., 2012). Petri and Plumer (2016) and Petri et al. (2012) omit firms entry and exit in their approach. 9 That is a crucial feature in a Melitz setting, which is included in our model. In this sense, the present model follows the path breaking approach of introducing Melitz in a CGE by Balistreri et al. (2011) to which we add the presence of foreign multinationals in services. In contrast to the CGE models that include multinationals, which are scarce, our specification incorporates imperfect competition, which seems to be more appropriate for sectors where multinationals operate. Some CGEs reviewed by Tarr (2013) and Latorre (2009) adopt a Dixit-Stiglitz monopolistic competition framework only in manufactures (e.g., Balistreri et al., 2015). 10 In contrast, the present model extends monopolistic competition to business services following Latorre and Yonezawa (2018) and Latorre et al. (2018), while additionally incorporating Melitz structure in manufacturing. Thus, our present model is closer to the one of Olekseyuk (2016), who already had Melitz in manufacturing with imperfect competition and multinationals in services, but multinationals with imperfect competition were modelled only in one of the regions of the multi-regional setting. In our model, FDI and multinationals are present in all considered regions. The present study can be also considered as an extension of the work by Olekseyuk and Balistreri (2017), who run Melitz, Krugman and Armington version of the model in a multiregional and multisector setting, but do not include the operations of multinationals in services. The initial database for the majority of micro and macroeconomic variables, as well as the inputoutput data of the model comes from the latest version of the GTAP Database (GTAP 9, Aguiar et al., 2016). Our model includes 11 regions, 21 sectors 11 and four types of production factors, namely, land, capital, labour and natural resources. 12 GTAP 9 resembles the world economy in 2011, and we conduct the forward calibration using IMF (2016) GDP projections for 2020 (following the technique described in Böhringer et al., 2009). This year seems to be a reasonable benchmark for estimation of the initial impact of Brexit. Therefore, it will be our reference year for the simulations. 9 To be more precise, there is no firm entry or exit in Melitz sectors in the studies of Petri and Plumer (2016) and Petri et al. (2012). Therefore, the total number of firms is exogenous and fixed. However, Melitz sectors still exhibit endogenous firm selection into bilateral markets. 10 Balistreri et al. (2015), in turn, are the first to develop a multiregional CGE in a literature of FDI in services, which had been previously constrained to single country models (e.g., Latorre, 2016). 11 Recall that Appendix 1 presents description of sectors and their mapping between different sectoral classifications. Appendix 2 offers the regional composition. 12 As commonly done in the literature, we model natural resources as a fixed factor of production in agriculture and other primary sector, which includes the extraction of coal, crude oil and natural gas. Land is also a fixed production factor in agriculture. Therefore, the output change as such is, to some extent, limited. 6

7 To quantify the impact of Brexit we simulate two different scenarios: hard and soft Brexit (following Ottaviano et al., 2014; and Dhingra et al., 2017). In the case of hard Brexit (i.e., reversion to WTO rules), we increase import tariffs between the REU and UK to the trade weighted average MFN level calculated using the external tariff rates of the REU and UK s bilateral trade flows with the rest of the EU. Moreover, the UK and REU will face an increase in their respective bilateral NTBs equivalent to 50 percent of NTBs that the US faces on EU markets. 13 We also assume an increase of existent FDI barriers between the UK and REU by 50 percent. In the case of soft Brexit (i.e., a post- Brexit arrangement similar to the one that Norway has with the EU) we remain zero import tariffs, but increase the NTBs and FDI barriers by 25 percent. 14 The scenarios seem to be a good choice to illustrate the potential outcomes of Brexit given no significant progress in the negotiations between the REU and UK. The MFN treatment is a possible scenario if the REU and UK are not able to negotiate a trade deal. It also represents the worst scenario for the Brexit partners. However, it seems reasonable that the UK will get an agreement with low tariffs or even a comprehensive free trade agreement with the EU, which could be closer to the soft Brexit or to the NTBs components of the hard Brexit scenario. For calculation of the potential tariff rates between the REU and UK, we use the external applied MFN tariffs of the EU from TRAINS for 2015 as well as trade flows for As the raw data is available on a disaggregated level only, we applied several correspondence tables from WITS to calculate both: (i) (ii) trade weighted MFN tariff rates that the UK might apply against the EU (weighted with UK's imports from the EU) and trade weighted MFN tariff rates that the EU might apply against the UK (weighted with UK's exports to the EU). Our calculations of FDI barriers between the UK and REU are based on the Product Market Regulation (PMR) indicators derived by the OECD (Koske et al., 2015). They are appropriate to deal with the EU internal market (Ecsip Consortium, 2014) and should be a good indicator to capture the differences among EU regulations. 15 Due to the common market, we cannot think of a more integrated region comprising different countries as the EU. However, it is also true that particularly in services, foreign multinationals from other EU countries do face barriers in their operations within the EU (Monteagudo et al. 2012; Mustilli and Pelkmans, 2013). Indeed, Jafari and Tarr (2017) provide different barriers to FDI in services across European countries. Therefore, we take outward 13 The NTBs to trade stem from Ecorys (2009) who additionally estimated the share of rents and efficiency losses that were behind the NTBs between Europe and the US. On average, 60% of the costs of the NTBs were found to be efficiency losses, while 40% would create rents. Additionally, they calculated that 2/3 of the rents were earned by importers and 1/3 by exporters. The 60% of efficiency losses are modelled as iceberg costs, using a common approach. Ecorys (2009) did not provide the barriers for Agriculture, Other manufacturing and Other services. For those sectors we take the estimations used by Latorre and Yonezawa (2018). 14 The UK faces less barriers (and, therefore, costs) in the European markets than the US does. Therefore, we increase UK-REU barriers by a fraction of the total barrier. It is hard to know the percentage costs, so we follow the approach of Ottaviano et al., (2014) and Dhingra et al., (2016). 15 The OECD PMR Indicators represent a comprehensive and internationally-comparable set of indicators that measure the degree to which policies promote or inhibit competition. We work with the recently updated trade and investment indicator since there is no estimation separating trade vs FDI 7

8 sales of UK multinationals in different EU countries and use them as weights to derive the total FDI barrier in the EU in each services sector. 16 Table 3 shows the increases in trade costs related to the barriers that will emerge between the EU and UK after Brexit. The first two columns show the resulting MFN tariffs that we model as an element of the hard Brexit. The next two columns present the NTBs related to trade and the final four columns the NTBs related to FDI in services. For both types of NTBs we have a soft and hard version with the above mentioned 25% and 50% shares of the total values of the NTBs, respectively. [Table 3 AROUND HERE] Table 3 shows that barriers are heterogeneous across sectors. With respect to trade barriers, they tend to be larger in agriculture, other primary (although only in the case of NTBs since tariffs are nearly zero), food, textiles, motor vehicles and other transport. For barriers to FDI they tend to be particularly high in business services and, to a lesser extent in air transport. These sectors with high barriers are likely to be the most affected by Brexit. Our modelling strategy consists of introducing what at first sight could be considered as rather high barriers related to trade and FDI. 17 We do this on purpose for two reasons. First, in order to provide an upper bound (or strongest impact) that Brexit could imply for both the REU and UK. Second, to better grasp whether Brexit could have any effects for outsiders. In any case, it is important to note, that after the initial assessment of barriers made by Ecorys (2009), Egger et al. (2015) have updated the estimations including even larger barriers to trade than the ones applied here, which tends to magnify the impact of the shock analysed. 4. Results 4.1 Microeconomic impact Bilateral trade within the Brexit block, intra-reu trade and trade with third nations. The direct impact of the emergence of trade and FDI barriers caused by Brexit will occur for bilateral trade flows between the UK and REU (Rest of the European Union). This shock will be later spread to trade flows with other regions. Table 4 displays three blocks of results: (i) trade within the Brexit block where we consider both REU imports from the UK (or UK exports to REU) and REU exports to the UK (or UK imports from the REU); (ii) trade of the Brexit block with third nations where we 16 We first take the FDI barriers as provided by Jafari and Tarr (2017). They provide estimations for 20 countries (instead of 28). Since the UK is one of the 20 countries, we use the estimates of the other 19 to proxy the FDI barriers for the REU. Second, we weight each country s barrier with the share of outward sales of UK multinationals in that country in overall UK outward sales going to the REU (using Eurostat, 2016 data). The FDI barrier that UK multinationals face is high (small) in sectors with large UK sales in the EU countries with tight (flexible) regulations. 17 UK is currently in compliance with the EU regulations, so most of the barriers will tend to grow as time passes by and regulations drift apart. However, depending on the type of trade relationship stemming from the negotiations, controls on the borders and other delays may arise automatically when Brexit is applied. 8

9 show the results of the REU and UK joint exports to the ROW (Rest of the World) and their joint imports from the ROW; and (iii) intra-reu trade which presents imports or exports within the EU- 27. We illustrate the impact of the soft and hard Brexit for all the sectors of the model as well as for the selected aggregates. [Table 4 around here] The reductions of trade flows between the UK and REU are pervasive. 18 The patterns of sectoral adjustments are parallel in percentage changes for exports and imports. This reflects the importance of the depth of the barriers that emerge with Brexit and vary across sectors, as shown in Table 3. The larger the increase in barriers is, the stronger the contraction in trade. That is why hard Brexit brings about stronger reductions in trade than the soft one, as the aggregate results for all the sectors show. It also explains why contractions of trade in manufactures are larger than in services. Table 3 clearly shows that barriers in services tend to be smaller than the ones in manufactures. As a consequence, trade in services is less affected than trade in manufacturing. Looking at the Brexit block in detail, REU imports from the UK decrease by % and % for aggregated manufacturing sectors and by -6.62% and % for aggregated services in the soft and hard Brexit simulation, respectively. For REU exports to the UK, in manufacturing they fall by % and % in the soft and hard Brexit case, while in services the respective figures are % % and -9.01%. Overall, aggregate bilateral trade flows would shrink considerably with REU imports diminishing by % or % in the soft and hard Brexit scenario, respectively, while REU exports would decrease by % and %. In general, sectors with the strongest reductions of trade flows are those with the largest barriers such as agriculture, other primary and food products, textiles and motor vehicles. The only sector with increased exports from the REU to UK is air transport in the hard Brexit scenario. Due to high FDI barrier in this sector (over 9%) and low NTB to trade (only 1%), European multinationals will switch from local supply in the UK (FDI case) to cross-border supply, i.e., export of services. The results on trade flows with third nations illustrate that after the emergence of trade and FDI barriers between the UK and REU, exporters in both regions lose sales opportunities within the Brexit region and look for new export destinations. In particular, total REU and UK exports to the ROW increase by 0.43% or 0.94% in the soft and hard Brexit simulation, respectively. The overall increase looks rather moderate, although we have to consider that this percentage changes apply to trade flows that are very large in absolute terms. On the sectoral level, other primary goods, food products, textiles, as well as agriculture tend to experience a stronger increase in exports to third nations. These are, in general, the sectors in which exports between the Brexit partners contract the most. Due to a trade diversion effect, exports to third regions in these sectors expand stronger than in the rest. The joint REU and UK imports of manufactures from third nations tend to exhibit a similar pattern as for exports: total manufacturing imports increase by up to 1.31% in the hard Brexit case. In particular, motor vehicles, food industry, other primary, metals, chemicals, other transport as well as agriculture extend their imports from the ROW strongly. This evolution largely explains the 18 Red shaded cells indicate reductions. 9

10 increase of aggregate imports from the ROW: the soft (hard) Brexit brings an increase of 0.43% (0.95%). The trend of joint REU and UK services imports from third nations is somewhat different at first sight: while total manufacturing imports increase, total imports of services decline by up to 0.61% in the hard Brexit case (see Table 4). In the soft Brexit simulation, both the REU and UK experience a small reduction of services imports from third countries by approximately -0.2%. However, in the case of hard Brexit it holds only for the REU: European services imports decline by -0.79%, while the UK increases its services imports by 0.38%. 19 Therefore, in the UK we observe increased services imports from the ROW with higher trade barriers in the hard Brexit case, meaning that there is trade diversion towards third countries in order to satisfy domestic demand for services. In contrast, the REU is able to replace a part of lost imports via increased intra-reu trade, which is seen in the last two columns of Table 4. Thus, there is no need to increase services imports from the ROW. Furthermore, European demand for services seems to drop strongly in the hard Brexit scenario, so that the REU do not increase services imports from the ROW. This is consistent with the overall result for the REU, that even with reduced domestic output and total imports, exports of services are slightly increased. Intra-EU trade reflects similar patterns as trade with third nations. After experiencing the emergence of significant barriers with the UK, REU firms will have strong incentives to search for markets or providers within the REU area, where no barriers exist. Therefore, after the soft Brexit intra-reu trade grows by 0.32%, while for the hard Brexit it rises by 0.75% Capacity to recover in other markets the lost trade within the Brexit block, productivity and variety losses As mentioned in the introduction, we aim at answering the following questions: Will the UK or REU be able to recover much of its lost trade after Brexit in other regions of the world? Who wins in that trade with third nations? Table 5 presents at its left the results for the percentage of REU lost exports to the UK that is recovered via REU exports to the rest of partners and separately via intra-reu exports. Note that trade with the rest of partners includes trade within the REU (i.e., intra-reu trade) and trade with third nations. In the right part of Table 5, we present the results for the percentage of UK lost exports to the REU that is recovered with UK exports to third nations. [Table 5 around here] Let us begin with the capacity of REU to recover the exports it loses with the UK by conducting more trade with all partners. 20 We can see that the percentages of total trade recovered are approximately one third (33.7% and 37.1% after a soft and hard Brexit, respectively). Around half of 19 The separate results for trade flows of UK and REU to third countries are not reported in Table 4 due to space limitations. 20 For all the values reflecting the capacity to recover lost trade due to Brexit in Table 5 we take the absolute values of trade with third nations (or intra-eu trade) in the numerator and divide them by the absolute values of trade lost by one of the Brexit partners in trading with the other Brexit partner. Trade between the Brexit partners falls in most of the cases, so we take its absolute value (without the minus). 10

11 the trade recovered is via intra-reu trade, while the other half is via trade with nations outside the Brexit block. In contrast, UK s capacity to recover its lost exports with the REU by trading with other partners is considerably smaller. The UK could recover as much as 6.9% in the soft Brexit scenario and virtually nothing (just 1.6%) in the case of hard Brexit. 21 Looking at the trade in services, the story is very different for the two Brexit partners. In particular, the REU recovers much of the services exports lost with the UK by exporting more services to third nations rather than via intra-reu trade expansion. The REU is also more successful in recovering exports in services than in manufacturing. In the UK the situation is opposite it is able to recover more trade in manufacturing than in services. Moreover, while in the soft Brexit scenario at least 3.2% of UK exports to the REU can be recovered by increased trade with third countries, there are even further losses in the hard Brexit case. 22 This illustrates that UK s services sectors will be suffering from Brexit most, which is consistent with the impact on sectoral output in Table 9. The fact that the REU outperforms the export capacity of the UK is intuitive given that the REU still has access to the huge common market, while the UK has lost that preferential access to the REU. This implies that European exporters should be able to retain important economies of scale after Brexit, while UK exporters should be more harmed. With implemented Melitz structure we can capture the evolution of (i) average productivity for firms operating in domestic markets (domestic productivity) and (ii) industry-wide average productivity which also accounts for firms exit and entry to/from third markets (see Table 6). The results indicate a reduction of both domestic and industry-wide productivity for the Brexit partners in almost all the sectors. 23 However, the magnitude is much lower in the case of the REU. While the maximal decline of domestic productivity in the REU occurs in motor vehicles sector with -0.62% in the hard Brexit scenario, in the UK this value amounts to -2.27% in several sectors such as textiles, chemicals, motor vehicles and electronics. This decrease of average productivity indicates entry of less productive firms due to increased protectionism and therefore less import competition. The fall of industry-wide productivity is even more pronounced in the UK with the maximum of -2.76% in food processing for the hard Brexit case. Comparing both productivity measures, we see that productivity is generally falling due to domestic entry of less productive firms and not because of exit from export markets, as the domestic firms productivity decrease is relatively large. [Table 6 around here] In addition to the negative producer-side impacts of Brexit, there are also negative consumer-side variety effects. Looking at the changes of the weighted average number of varieties in services, which includes both domestic and FDI firms weighted with their market shares, we observe a decline across all services sectors for both Brexit partners with stronger reductions in the UK (see Table 7). Moreover, increased protectionism forces highly productive REU firms to exit from British market in all Melitz sectors with the highest reduction of supplied varieties by 88.86% in food processing in 21 This result occurs without taking into account possible FTAs between the UK and third countries that might be negotiated and adopted after Brexit. 22 In this negative case (-6.6%), UK does not increase its exports to other partners as it does in the rest of scenarios. Instead, the UK decreases them, thus, losing not only exports going to the EU but also UK s exports going to third partners. 23 The only slightly positive changes are observed in other machinery and construction. 11

12 the case of hard Brexit (see Table 8). British firms are also forced to exit the REU market and to switch to domestic supply in order to replace the lost imports. In general, we observe an increase in the number of domestic varieties for both sides but with much higher changes in the case of the UK. And while the total number of consumed varieties in the REU is negative across all the sectors, it is positive for the UK, providing a misleading impression of a positive result. It turns to be a negative effect once firm-level prices and quantities of heterogeneous firms are taken into account. To evaluate the variety impact in Melitz sectors, we calculate the Feenstra ratio an index of the consumption-side variety impacts on welfare suggested by Feenstra (2010), which accounts for differentiated firm-level prices in the context of Melitz model. Table 6 illustrates the percentage changes (relative to unity) in the Feenstra ratio for all Melitz sectors and indicates welfare losses along the extensive margin for both the UK and REU. Thus, UK s losses are much higher illustrating the fact that the UK loses many imported varieties (produced by highly productive European firms) with low prices and high quantities, while the new domestic varieties are produced by firms with lower productivity and therefore at high prices and small quantities. [Table 7 and 8 around here] Total exports, imports and production in a sector by sector analysis The aforementioned reductions in bilateral trade flows translate into overall reductions in exports and imports across the board in both the REU and UK. However, they are more intense for trade flows of the UK than for REU, as the REU accounts for a larger share of UK s trade than vice versa (see Tables 1 and 2). This is what we see in Table 9, which offers the evolution of total exports and imports of each sector in the UK and REU after the soft and hard Brexit. In particular, aggregate exports shrink by -7.54% and % in the UK after the soft and hard Brexit, respectively, while in the REU they go down only by -1.54% and -3.48%, respectively. Similarly, aggregate imports of the UK decrease by -6.44% and % in the UK, whereas in the REU they decline only by -1.69% and -3.82% after the soft and hard Brexit, respectively. The strongest reductions in trade flows occur in sectors such as food, agriculture, motor vehicles, other primary and textiles; thus in the sectors with the highest barriers to trade. 24 While imports decline in all sectors of both regions 25 as well as British exports fall in all sectors, the REU is able to increase its exports of services such as construction, air transport, insurance, other and personal services in the case of hard Brexit. 26 These developments even lead to a small increase of total European services exports by 0.07% in the hard Brexit scenario, mainly due to increased trade with the rest of the world. [Tables 9 around here] The contraction of foreign trade is associated with the more sizeable output reductions in the UK compared to the REU (see Table 9). Aggregate output in the REU is nearly unaffected after both the 24 This confirms that sector-specific NTBs are very important for measurement of Brexit impact. However, this aspect has been neglected in some analyses of Brexit, which use homogeneous NTBs across sectors (e.g., Ottaviano et al., 2014; Dhingra et al., 2017). 25 Except the imports of air transport services in the UK for hard Brexit case, which has been already described above. 26 Note that these sectors, in general, tend to face the smallest NTBs to trade across all the sectors and no tariffs. 12

13 soft (-0.15%) and hard Brexit (-0.33%). However, in the UK the overall contraction constitutes % and -2.46% for the soft and hard Brexit, respectively. Moreover, UK s total output of services goes down by -1.35% vs % in manufactures in the soft Brexit scenario, while in the hard Brexit case these figures amount to -3.02% vs %, respectively. In general, output contractions are more intense in the sectors that experience stronger reductions in trade due to the emergence of larger barriers to trade and FDI. Thus, in the REU production falls stronger in food processing, motor vehicles and agriculture, while slightly positive changes occur in other transport, machinery and water transport mainly to satisfy domestic demand. In the UK, the strongest reductions in output are observed in sectors such as other primary, electronics, air transport and business services. The evolution of food and motor vehicles in the UK is exceptional, however, because their output rises. These sectors are the most dependent on imports coming from the REU. As shown in Table 2, 74.7% and 84.3% of their imports come from the REU, while the average across manufactures is 49.9%. This fact combined with rather large NTBs and tariffs bring about a very remarkable reduction in its overall imports. Although their exports also fall, the need to saturate domestic demand for motor vehicles and food products leads to increases in their production. 27 The number of domestic firms confirms this development as it increases strongly in these sectors with the highest value of 19.61% in the motor vehicle production, followed by 13.65% in food processing (Table 8). Thus, less productive British firms enter the local market to supply products at high prices and low quantities (i.e. losses along the extensive margin are the highest in motor vehicles and food processing, see Feenstra ratio in Table 6). In sum, the microeconomic results reflect a much stronger impact of Brexit in the UK than in REU for exports, imports and output on a sector by sector basis. The two regions are, of course, quite different in size. This implies that small percentage changes in the REU may seem very limited for the entire region, but may also hide more sizeable impacts for the individual countries. This is certainly an issue for future research. However, two important conclusions can be derived from our outcomes so far. First, the damage derived for the UK is sizeable because nearly half of its aggregate imports and exports will experience the emergence of barriers. None of the countries within REU will have such a strong relationship with the UK alone. Therefore, in all likelihood the impact for all the countries within the REU would be less intense than the one for the UK. A second important conclusion from these results is that the REU as a whole is not much affected by Brexit. This region is an important player in world imports and exports. Therefore, it would have had the capacity to bring about important trade diversion or creation effects. However, because the REU is not much affected, the latter effects are small. We will confirm this now by looking at the macroeconomic impact for all the regions included in our model. 27 We additionally performed a sensitivity analysis to further analyse the evolution of motor vehicle sector as example. For this purpose, we redistributed UK s total imports by the region of origin: we reduced the share of imports from the REU to 19% and doubled the one from other regions. The results indicate that being less dependent on REU imports, sector s output would also go down just like in the rest of sectors. Note also that only a small share of imports of this sector is used as intermediates (18.28%). The same applies for food industry where only 26.12% of imports are intermediates, in contrast to the rest of sectors with an average of 56%. The particular use of imports for intermediates and (different types of) final demand plays a significant role to explain the differential behavior of sectors, as has been deeply analysed in Zhou and Latorre (2014a, 2015b). 13

14 4.2. Macroeconomic impact Table 10 offers the impact for GDP, welfare, wages, capital remuneration and the Consumer Price Index (CPI) for all the regions considered. For these aggregate variables we present the effects of the different components of Brexit separately as well as the total impact for both soft and hard Brexit. Thus, for the soft Brexit, which appears on the left, we include increases in NTBs to trade (labelled as NTBs in the table) and increases in NTBs to FDI (labelled as FDI barriers ) and their joint impact ( Total ). For the hard Brexit, we add the impact of MFN tariffs (labelled as Tariffs ) to the two former components, which now imply larger increases than in the case of the soft Brexit (as reflected in Table 3). [Tables 10 around here] In line with the evolution of trade and output results on sectoral level, we observe a much stronger reduction in UK s GDP, welfare, wages and capital remuneration than in the REU. GDP in the UK could experience a contraction between -1.23% and -2.53% in the case of soft and hard Brexit, respectively. In contrast, for the REU the fall in GDP is only between -0.16% and -0.35%. Welfare reductions, measured as Hicks equivalent variation of consumption, are more pronounced than the ones of GDP: UK s welfare loss reaches -3.17% in the hard Brexit scenario, while the one for the REU amounts to -0.59%. Translating the percentage changes of welfare into billions of US dollars in 2020 (which is the base year of our simulations), the value of maximal consumption loss after the hard Brexit constitutes $billions for the UK and $billions for the REU. In the case of soft Brexit, the drain would be of $billions (-1.56%) in the UK and of $billions (- 0.27%) in the REU. Concerning factor remuneration, British workers and capital owners would suffer more from Brexit than the ones in the REU. In particular, the maximal reduction of wages and capital remuneration in the hard Brexit scenario amounts to -2.83% and -3.34% in the UK, while in the REU it takes only % and -0.43%, respectively. Moreover, in the UK the decline in wages is lower than in capital returns indicating a relatively lower demand for capital that occurs due to a reallocation of production to the labour-intensive sectors (e.g., food processing and motor vehicles with the share of labour in value added of 60% and 80%, respectively). Capital owners lose stronger from FDI barriers as a part of capital in services is sector-specific and cannot reallocate due to emergence of new inefficiencies. Looking at the distribution of the negative impact among the different types of barriers, NTBs to trade account for the largest share of the total negative impact. More precisely, in the hard Brexit simulation the rise of NTBs constitutes over one-half of the total negative effect for both the UK and REU across macroeconomic variables such as GDP and welfare. FDI barriers also play a significant role, since they explain approximately one-third of the decrease in GDP and welfare in the two regions. The results for wages and capital remuneration also run in parallel to the ones for GDP and welfare implying that NTBs to trade account for the largest reduction in factor remunerations. Generally, higher barriers after Brexit increase prices for imported products in the UK and REU. In addition, entry of less productive producers due to increased protectionism also raises prices. This leads to a higher Consumer Price Index (CPI) in the UK with the maximal increase of 1.28% in the 14

15 case of hard Brexit (see Table 10), which reduces the demand and consumption of goods and services. This in turn drives production and trade down, which is associated with lower demand for inputs and therefore lower factor earnings, as described previously. Additionally, there is a considerable welfare loss along the extensive margin of trade as indicated previously by the Feenstra ratio. In the case of the REU the impact is not that strong as it is not dependent on the British market as much as the UK on the European one. Moreover, as mentioned before, the REU is able to recover much of its trade by increasing the unrestricted intra-reu trade as well as trade with third countries. Therefore, the CPI in the REU is almost unaffected or even slightly reduced, while the overall negative Brexit impact is quite limited with the highest welfare loss of 0.59%. Considering other regions of the world, they are nearly unaffected by Brexit. We estimate a small percentage variation in welfare for the Middle East region (MEN), other advanced economies (OAC) and the US, which implies a few billions of extra dollars. This even holds for the hard Brexit which could result in more intense trade diversion or creation effects. However, since the UK accounts for a small share of the world GDP and trade, the potential spillovers from Brexit for outsiders seem to be quite damped. 5. Sensitivity analysis As a robustness check of our results, we assess the impact of the key model parameter values in our piecemeal sensitivity analysis where we change each parameter one by one, while we keep all other parameters unchanged. Table 11 shows how the welfare impacts of the hard Brexit on the UK and REU are affected by each parameter. In addition, we re-run the model with an Armington structure, which is the most common and standard specification of trade in the literature and has been widely used in previous studies on Brexit. We see that our welfare results are generally quite robust to the parameters here. The parameter that has the strongest impact on the welfare results is the elasticity of substitution between value-added and business services, σ(va, bs). Table 11 shows that the welfare impact of the UK (REU) ranges from -2.77% (-0.46%) to -3.68% (-0.77%). This implies 87% (78%) to 116% (130%) relative to the central result. When this elasticity is higher, firms can substitute the business services for valueadded input more easily, which leads to the larger decrease of the business services from multinational firms and cross-border firms after the Brexit. This is because the latter become more expensive due to Brexit barriers. As a result, the production of services is reduced stronger, the business services will be more costly and welfare loss of the economy larger due to reduced number of available varieties in the love-of-variety setting. The elasticities of substitution between firm varieties have modest impact on the welfare results. Especially, when the substitution elasticity between firm varieties of service sectors is lower, the welfare impact is not small: -3.65% (-0.69%) for the UK (REU) or 115% (117%) for the UK (REU) relative to the central results. When this elasticity (for both service sectors and good sectors) is lower, the welfare loss becomes larger because lower values of this elasticity imply that varieties are less close to each other, and thus fewer varieties are more damaging. 15